jim.shamlin.com

Nature, Goals and Models of Corporate Governance

In the wake of recent financial disaster, the business world has shown a renewed interest in effective corporate governance - that is to say that they are rushing to do the things they should have done before voluntarily, before government regulators force an even more inconvenient solution upon them. As such, may of the actions being undertaken are superficial, for the sake of appearances, rather than effective, and government intervention in private industry is likely inevitable.

Case Studies

The author intends to present some real-world situations related to a few of the basic problems of corporate government. These are not the only instances in which problems have arisen, nor is this brief treatment intended to be a comprehensive exploration of the issues, merely a sampling to give the reader a sense of the kinds of situations that arise as a result of poor governance.

The rage about executive compensation

In July of 2006, during a booming economy, Fortune magazine published "The Real CEO Problem," an article that described shareholder outrage over the ballooning executive compensation and the reason shareholders seem to be powerless to stop the bloat in compensation systems that seemed to be broken. Shareholder outrage turned to public outrage a few years later, when the financial crisis exploded and the executives of failing firms continued to draw lavish compensation while running their firms into the ground.

The root of the problem was the compensation system itself, which obliged firms to make payment to executives based on agreements that seemed functional when times were good, rewarding executives in step with the financial results, but were clearly inefficient and unjust when the firms were failing because they were based on specific factors that could be maintained even when the overall performance of a firm was terrible.

The example is given of Shell, who in May 2009 held a token vote among shareholders in which the majority indicated an interest in withholding a significant bonus (over 4 million Euro to be paid to five executives). The vote was not binding because the company was obligated to make payment based on metrics that had, in fact, been satisfied by the executives' business units - but it sent a clear signal about how the shareholders felt about the compensation program the firm had adopted.

The debate about compensation is not merely in the effectiveness of the system itself, but in the lack of input that the majority of shareholders have into governance: the compensation scheme was defined and approved by the board of directors without approval, or even scrutiny, of the shareholders. This highlights one of the most serious issues in corporate governance.

Large shareholders and family-controlled firms

The author details the 2009 attempted merger between Volkswagen and Porsche (EN: which ultimately failed, though was likely an ongoing issue at the time this book was written) - called a "merger" because it was unclear whether Volkswagen was acquiring Porsche or vice-versa.

Porsche was a small and privately-held firm, whereas Volkswagen was much larger organization, the largest European automobile manufacturer with ten successful brands. Moreover, the owner of Porsche and the chairman of Volkswagen were cousins, and members of the family that had 100% ownership of Porsche.

Porsche had begun acquiring Volkswagen in 2005, and by 2009 had amassed a 51% stake in the firm by amassing an equally impressive amount of debt to acquire the shares. The financial weakness gave Volkswagen a tactical advantage in the merger, and there were conflicts among the members of the family as to how to combine the firms.

The minority shareholders in Volkswagen used the various legal tools at their disposal to defend their interests in the merger, to ensure that the family did not use its power to disenfranchise them - including a spate of lawsuits and regulatory snarls.

Europe is a particularly interesting example because many of its firms remain tightly controlled, with individuals (often organized around a wealthy family) hold a greater stake in corporations that institutional investors, and wield considerable power to manage the firm to suit their own interests, to the detriment of other investors. It is also of interest because, unlike in the US, governments may invest their own treasuries in firms, and generally do so as minority shareholders and refrain from intruding upon the operations for the sake of preserving free enterprise - which then, in effect, gives greater autonomy to majority shareholders.

Government intervention in mergers and acquisitions

The author provides a few examples of instances in which the French government has acted to prevent foreign firms from acquiring domestic ones, or enable domestic firms to acquire foreign firms, to ensure the control of the firms remained under the control of French citizens, who themselves remained under control of the French government.

This is somewhat different to similar actions undertaken in the mid-twentieth century, during which time the government would invest in domestic firms by purchasing a controlling share, effectively nationalizing them. In later years, the government used its influence to prevent the sale of firms in which it had no formal ownership.

While the short-term benefit of intervention on this scale achieved its intended effects, the long-term result was to discourage foreign investment in French companies, as well as discouraging foreign firms from entering into any form of partnership agreement with French firms. As such, France has disproportionately few global corporations give the size of its economy

The author finds it "intriguing" that in such instances, most of the discussions surrounding the deals related to the role of government in strategic decisions, and not to the quality of the decisions themselves, nor to the strategic benefit to the firms involved in a potential merger, nor to the impact the mergers would have on customers, employees, shareholders, and the community.

While there is some criticism of government intervening in private enterprise, forcing an agenda that favors one party to the detriment of others, this is not significantly different to the damage done when a board of directors makes similar decisions based on their own financial interests, disregarding the impact to other parties who, while negatively affected, have no input or representation in the negotiations.

Chief Executives, Boards of Directors, and Regulators

The focus on maximizing profit has caused senior managers to disregard the long-term development of the firm, and has served the interests of a small number of shareholders who have a strong influence with the board of directors. Also, it's been noted that in recent years many chief executives have taken on an enormous degree of power, well beyond that which is granted them by their companies' bylaws, whether from their own desire to amass power or because their boards have been inattentive or neglectful of their duties.

Things were not always thus. The 1990s saw a number of significant changes in the world of investments:

The confluence of these factors led to a larger number of disinterested investors as well as increasing power to executives, both of whom focused almost exclusively on increasing the market value (stock price) of a firm, which is often subjective and detached from the actual value or productivity of companies.

(EN: The author catalogs high-level causes, but my sense is it can be traced to deeper roots, chiefly two phenomena: first, the shift from traditional pensions to private retirement accounts invested in mutual funds caused a surge in investing by individuals who do not consider themselves to be investors and who are often unaware of the firms in which their funds are invested; second, and to a lesser degree, internet trading has opened markets to many speculators who are entirely focused on stock prices and not corporate ownership.)

The desire to improve the price of a security issued by a firm is not inherently bad, but if it becomes the primary goal, supplanting the health and profitability of the firm, it can be devastating. There is a significant difference in the sound use of resources to ensure a company's future and the application of resources to influence the daily fluctuations in the price of its stock.

Where investors are focused entirely on increasing the value of their portfolios and executives are focused on that of the securities they have been granted as compensation, the firm is managed by factors other than increasing its actual long-term value. In view of this situation, the author suggests that "many boards of directors" have chosen to reclaim certain basics functions "which they never should have given up in the first place."

The author suggests that the spate of dismissals of chief executives at major firms to reflect the boards' reaction to those executives having overstepped their authority and seized too much power. That is, firing an autocratic CEO is the first step shareholders take in regaining control over the firm. However, this is not always so: replacing one executive with another is not a guarantee that the new one will behave any better. A firm will likely not undergo a significant change by the replacement of its leadership unless the board itself also changes its long-term perspectives, the goals of the organization, compensation packages, and its governance mechanisms.

The author expresses doubt that the "shareholder activism" witnessed in recent years is necessarily a positive force or a sign than institutional investors are taking back their responsibilities. Primarily, shareholders are not necessarily good businessmen or skilled leaders - their expertise and interest is in managing investments rather than managing firms, and many of them invest in multiple firms that are in competition with one another, such that direct participation in management would constitute a conflict of interest. Second, the institutional investors are often interested in short-term profitability as a measure of their own performance in managing portfolios - they are more likely, rather than less, to seek short-term financial gain than long-term sustainability of the firms in which they invest. Third, board members are not immune to the allure of amassing personal power and serving their self-interest at the expense of other stakeholders and, being diversely invested, have no particular loyalty to any of the firms in which they have a stake.

As an aside, government regulators have offered little in the way of a solution, and are likewise motivated not to ensure the long-term success of companies, but merely to mollify and curry favor with the voting public. Regulators are also not skilled at managing companies, and managing firms well is not in line with their personal interest. At best, regulations refrain from intruding on the operations of firms but merely require of them greater transparency - but transparency is not a solution where board members are inattentive and indifferent to the information that is exposed, much of which has always been available to them had they bothered to request it.

Ultimately, the governance of a firm, whether internal or external, is not a solution to the present problem. Governance pertains to matters of procedure - it does not specify what the goals of an organization must be, but merely dictates the procedures to be followed in pursuit of a company's goals, whatever they happen to be. In effect, a company may be governed well, and may be attentive to requirements and procedures, and still pursue the wrong goals by the wrong methods in terms of the soundness and contribution to the long-term welfare of the firm and its stakeholders.

Owners and Managers: Who Controls What?

A common characteristic in the distinction between ownership, management, and control is the nature of roles and the specialization of skills: resources are allocated and authority vested where it is most effective, appropriate, and productive. A proprietorship with a very small number of employees can maintain the majority of authority in a single individual, the owner-manager, but when a firm grows beyond a certain size, authority must be delegated. Especially in corporations, where many investors who have little skill at a business may maintain a stake in its ownership, responsibility and authority is delegated to a group of professional managers.

Nevertheless, the separation of ownership from control has also generated "significant dysfunctions." In 1932, Berle and Means identified a number of risks in separating the two, inherent and fundamental conflicts that remain problematic even in the present day. For example, where an owner who cedes too much authority also cedes the ability to influence decisions that have a significant impact on the firm. Also, where authority is divided up among many people, it disperses and fragments operations, such that different groups end up working at odds with one another. Delegation not only disperses power, but also disperses knowledge, and is particularly problematic when the owners of a business lose a sense of purpose, if indeed the owners had a clear sense of purpose in the first place.

Given that most shareholders hold a portfolio of securities, and many invest in vehicles such as mutual funds where they may be entirely unaware of the myriad of firms in which they have an ownership stake, and that many investors do not have acumen in the businesses in which they invest, it is likely that they have little understanding of the operations of the firms they own and do not have time to educate themselves or keep abreast of current events in a multitude of different firms. They must delegate authority to skilled employees who can devote adequate time and expertise to decisions regarding the firm.

It's also noted that, in many countries, the roles of chairman of the board and chief executive are vested in a single person. This avoids the separation of ownership and control, but also foregoes the advantages of delegation, and has historically failed to guarantee success. Whether the interests of shareholders and management are represented by one individual or two, there are still conflicts of interest that must be resolved without capitulation to one or the other.

Corporate Governance Models: International Perspective

The content and objectives of corporate governance are strongly influenced by their environment: they are subject to the legal requirements of a specific country and to the cultural norms of a specific society. There is no universal template, and the bylaws and governance mechanisms of any firm are voluntarily adopted by the parties involved. Moreover, the system of preference in one nation is not necessarily suited for adoption in others.

The British model

The UK has a strong tradition of corporate governance founded on common law. Consider the Royal Charters once granted by the crown to organizations such as the East India Company and other such organizations, which have provided a pattern for the British notion of the corporation. The EIC was governed by a general assembly (Court of Proprietors) and a board of directors (Court of Directors). The former were likened to the mass of common stockholders, each of which had invested in the company, and the latter acted as an executive committee whose decisions required ratification by the proprietors.

The British financial structure is very similar to the US model, with capital markets under private control and little government interference, particularly after a wave of deregulation in the late 1980s. However, the author asserts that the current British system is modeled on that of the US rather than the other way around, given that the British took the lead from the American institutions in the latter half of the twentieth century.

One significant difference is that British firms tend to keep the roles of chairman and CEO entirely separated, and the status and power of executives in Britain is generally lower than that of their American counterparts.

A second difference that has emerged recently is that the US system, especially under Sarbanes-Oxley, is more tightly regulated and controlled whereas Britain continues to follow the classic tradition of "comply or explain", placing fewer legal requirements on corporations.

The German model

By contrast, the German system of corporate governance is the polar opposite of the American system. The German financing model is of a bank-backed system in which firms are obligated to pay their financiers according to the terms of the financing agreement, but do not allow them much influence over the business itself.

While this has changed much in the last decade, with German firms turning more toward private ownership, the author feels it would be "premature" to suggest that Germany is coming into line with the Americans and the British: banks still have significant presence in companies and the slow growth of their capital markets suggests that the transition will take considerable time and the historical characteristics of the German model will linger for years to come.

A distinctive feature of corporate governance in Germany is that companies have two governing bodies: a management board and a supervisory board. This may seem similar to the executive and shareholder roles in US companies, but there remain significant differences.

The management board in German firms have more decision-making authority than the executives of American firms, and the status of board members is more equal and their decision-making process more collegial than in American firms, in which a CEO has ultimate control and authority.

Another distinctive features is the presence of controlling shareholders in most firms -the banks, capitalists, or families who originally funded the firm maintain a majority of the shares and a significant level of control. It's remarked that other continental European nations such as France and Spain have systems more like the German one, with concentrated ownership by a few parties.

Another strange practice is the notion of co-determination, in which firms of a certain size are obliged to include employee representation on the supervisory board, in such a manner that the rights of the workers are represented in corporate governance. The natural drawback is that such persons often lack professional expertise, which tends to slow down and complicate decisions by the advisory board.

The net result of co-determination and controlling shareholders is not always positive. In some instances, it leads to greater harmony, in others greater dissonance, as there arises a small circle or core of powerful individuals who have effective control over a firm, and who tend to be in a difficult position in times where responsiveness to rapid change is required.

Convergence: For and Against

The overview of corporate governance models may seem to suggest that these models are converging, and there are other factors that would support this conclusion:

On the other hand, convergence faces certain obstacles:

In all, there are significant forces pushing for the adoption of uniform governance standards at the global level, yet other forces resisting for good reason. The author's assessment is that we can expect convergence, driven largely by the desire to adopt best practices, but it will be a very slow process.

Alternative Perspectives on Corporate Governance

Corporate governance can most readily be observed in the management systems and policies that guide the company in its regular operations and the choice of new projects it opts to undertake. But the goal of governance must be the company's long-term development and pursuit of its mission, meanwhile maintaining viability in a competitive environment.

The author acknowledges that firms may persist for a time by merely seeing to the perpetuation of operations, but suggests that such a firm is "merely a business" in the sense of busying itself with activity, rather than seeking to fulfill a mission, which is the proper purpose of a company.

A firm that has a mission and values has a clear objective, even in times of change. If change in the environment renders its activities inefficient, or completely pointless, it changes them with the purpose of achieving its goals, and if it accomplishes its goals, it can set new ones in support of a broad mission. Further it is mission that gives meaning to the activities of a firm and purpose to its people.

With that in mind, the board and executive committee must recognize that a firm can be successful if its activities are directed toward the achievement of its mission, though it also requires it to be differentiated from other firms in ways that make it more efficient of effective - that is, its competitive advantage arises in that what it offers is different to what its competitors offer in a way that its customers value.

A high level of turnover in executive positions in a firm is a distinct signal that the board of directors is incapable of engaging in long-term thinking, but instead responding to the events of the day. Such a firm lacks a strong sense of purpose and as a result does not have continuity or the ability to envision a distant future, and is likely not to be see the distant future.

The financial and legal perspective of corporate governance, are often directed toward short-term objectives and merely encourage or discourage certain specific behaviors without an eye toward to purpose and mission of the firm. While they are not entirely without value, they are insufficient to the need of the firm for guidance over a long period of time.

With regard to ownership, it is important for firms to have a majority of shareholders who have significant wealth invested in the firm with the intent to continue to profit from their investment over a long period of time. The greater their number, the most conflicts of interests arise; and the briefer their tenure, the shorter their horizon. The presence of large shareholders may at times be a stumbling block to taking swift and effective action in response to an immediate situation, but it can also be argued that such situations are unusual rather than the norm, and that the penalty of failure to act swiftly is in any case less detrimental and easier to amend or recover from than the systematic failure to act correctly.

Within an industry, competition among firms influences the quality of corporate governance. In theory, the existence of competitors should cause the executive team to be more careful in making decisions and consider their impact on the firm's competitive position; but in practice, it often causes executives to be rash and reactive rather than deliberate and contemplative.

Another mechanism that can contribute to or detract from sound governance is the potential threat of hostile takeover - but this also results in some acutely poor choices a firm might make: to make the firm unappealing to unwanted investors often results in actions that make the firm unappealing to customers. The "poison pill" taken to case a bidder to pause affects many other stakeholders as well.

On the topic of takeovers, hostile or otherwise, "empirical studies have proven" that they are most often harmful to the health of both firms, and that the financial performance and commercial success of firms suffers greatly in the wake of even a congenial merger or acquisition. (EN: I can't accept that statement at face value without closer examination of the studies - but even without them, this seems too general: the aggregated view of M&A during a certain period of time, or even over all time, might support this, but what is statistically true of a population isn't necessarily true of each instance. That is to say: the fact that many mergers are ill-conceived and poorly executed does not mean that a merger cannot be wisely conceived and well executed.)

The author also points to a problem of considering governance as a thing unto itself, and attempting to define universal policies and procedures that constitute good governance for all firms, in all industries, in all markets, in all locations, etc. However, this is myopic: governance is not undertake for the sake of governance itself, but to govern the firm to adhere to its mission and values. Just as there is no single mission ands et of values for all firms, so can there be no universal method of governance.

Some Final Thoughts

This chapter has exampled some of the problems for corporate governance, and considers as a source the separation between ownership and management in modern economics which, while necessary, has lead to a rift between the interests of managers and those of owners.

To this end, a balance of power must be achieved between the chief executive and the shareholders of a firm, and their interests must be aligned toward the long-term success and survival of the firm.

The present focus on governance as directed toward legal and financial ends is entirely unsatisfactory and unlikely ever to result in the desired end. The legal and financial perspectives are only two among several that are needed for good governance. The present practice of focusing governance on the ritual activities of employees rather than the purpose to which activities are undertaken is likewise insufficient.

Finally the author has indicated factors such as competition and acquisition that have distracted governance from the purpose of the firm.

JIM.SHAMLIN.COM
DISCLAIMERS · CONTACT